If there were any doubts that Indian companies were risk-averse when it came to making big-ticket acquisitions overseas, the proposed buyout of the $17.5 billion Anglo-Dutch steel maker Corus by the $5 billion Tata Steel has all but cleared them. While it is possible that Tata Steel may eventually lose the deal to a higher bid from Brazil’s CSN, the size of its ambition is remarkable. (Tata Steel and CSN have increased their bids twice each during the past month. CSN’s latest offer is $9.6 billion; Tata Steel is expected to counter that shortly.)Tata Steel does not have ready cash to pay for the acquisition. It will have to leverage both its own balance sheet and that of Corus to finance the deal with borrowings of at least $7 billion, possibly more.
Is this a case of Third World chutzpah? Not really, if one considers the huge amounts of money chasing promising deals driven by strong balance sheets and proven management teams. More and more foreign investors, bankers, private equity and hedge funds are betting on and backing Indian companies in the latter’s foreign acquisitions. Both Indian acquirers and foreign sellers seem to prefer cash over stock swaps, while some have worked out ingenious financial engineering for tax breaks. India’s regulatory environment for overseas acquisitions has also joined the party with a relaxed regime. India Knowledge at Wharton spoke with leading corporate acquirers, foreign investors, bankers and consulting firms operating in the Indian market to learn how the M&A boom is being funded.
Strong Cash Flows
More and more Indian businesses come to the deal table smelling good. “Most Indian firms have strong cash flows and low gearing,” says Sanjiv Bhasin, CEO and managing director of the Dutch Rabo Bank’s Indian operations. “This, together with the lenders’ confidence in these companies and India’s high credit rating, makes it easy for firms to borrow from the market.” Bhasin’s bank put together the funding for Tata Coffee’s $220 million buyout in June 2006 of the U.S. brand Eight O’ Clock Coffee and also Tata Tea’s purchase two months later of a 30% stake for $677 million in the Whitestone, N.Y.-based Glaceau vitamin water maker Energy Brands. Tata Steel has already cobbled together a loan of £3.5 billion ($6.8 billion) from Standard Chartered, Credit Suisse, ABN Amro and Deutsche Bank for its Corus bid.
James V. Abraham, vice president and director at Boston Consulting Group, says foreign investors have high expectations about the prospects for Indian firms. “That is why they are willing to buy equity in these companies at a premium.” Adds Jayesh Desai, head of investment banking at Ernst & Young, “Confidence in Indian companies is rising with every quarter as they continue to achieve scale, strategize intelligently and report strong numbers. While it is true that globally there is a large amount of cash looking for assets, it is also true that demand for products and services in India has never been more buoyant. The India story is beginning to look more attractive, and that is what is convincing lenders.”
Dhanraj Bhagat, practice director at accounting and consulting firm Grant Thornton, says India now appears promising relative to other countries. “With other economies and markets not performing as well, lenders are naturally looking at markets like India,” he says. “This is true of banks and private equity funds.” Sunam Sarkar, head of strategy and marketing at the $675 million Apollo Tyres in Gurgaon in India’s Haryana state, will testify to that sentiment. This past January, his company bought Dunlop South Africa for $60 million in an all-cash deal. “A couple of private equity funds had approached us even before we had closed out the deal to tell us that they would back us with funds if we needed them,” says Sarkar. “We had absolutely no problem mobilizing the money as even our local bankers were willing to lend us the amount at a reasonable rate.” The company plans to raise $75 million through an equity placement with institutional buyers.
The average deal size for Indian M&A aspirants has also grown in the past two years. As tracked by Grant Thornton, the average deal size in 2005 was $32 million. By the first half of 2006, the average deal value was $47 million. In some cases, the deal size was bigger than the acquiring Indian company’s revenues. For instance, the $41 million Bangalore-based telecommunications consulting firm Subex Systems bought Azure Solutions of the U.K. for $140 million in April 2006; the combined entity is now called Subex Azure. Another is the $113 million Chennai-based energy support services firm Aban Offshore (formerly Aban Loyd Chiles Offshore), which bought a 34% stake in Norwegian drilling company Sinvest ASA for $446 million in June this year. The number of such overseas M&A deals also appears to be on the rise. In the current year through October, Indian acquirers have closed 145 M&A deals valued at $7.8 billion, according to Grant Thornton. In contrast, such deals numbered 136 with a total value of $4.3 billion in the whole of 2005.
Four years of sustained growth — corporate earnings have increased by 20% to 25% on average — have boosted the profitability and strengthened the balance sheets of Indian companies. Total cash flows for the Indian corporate sector were about Rs. 200,000 crore ($45 billion) in 2005-2006, according to a study done by Business Standard Research Bureau. Burgeoning domestic demand driven by low interest rates, higher disposable incomes, changing lifestyles and growing aspirations are other factors that have helped Indian firms. BCG’s Abraham notes, “Fundamentally, Indian firms are in sound shape, and investors are convinced that they will be able to add value to the acquired company. That’s why they’re prepared to back them.”
Commodity players are among the biggest beneficiaries, especially steel and cement makers that have enjoyed higher prices. This, together with a greater ability to leverage, has given them the confidence to make large acquisitions. A case in point is truck and car maker Tata Motors, which has recovered from a loss of Rs. 500 crore ($112 million) in 2000-01 to a profit of Rs. 1,728 crore ($388 million) last year. Its improving fortunes emboldened it in March 2004 to pay $102 million for the assets of the ailing Daewoo Commercial Vehicles in Korea. Another major acquirer is Dr. Reddy’s Laboratories, which in February this year struck a $575 million deal to acquire Betapharm Arnezeimittel, Germany’s fourth largest generic drug maker.
Unlike most international M&A transactions that typically feature stock swaps in the financing arithmetic, Indian acquirers have for the most part paid cash for their targets, helped by a combination of internal resources and borrowings. Share swaps have not yet emerged as a favored payment option in India, except in a couple of large transactions in the software industry where the sellers (some, incidentally, of Indian origin) have been willing to accept the stock of the Indian company. Subex’s $140 million purchase of Azure, for instance, was essentially a stock transaction with the cash element limited to 2% to 3%; the sellers were predominantly venture capitalists. Another exception was Videocon’s purchase — through an offshore entity — of Thomson’s global color tubes manufacturing business; Thomson picked up a Rs. 1,200 crore ($270 million) equity stake in Videocon.
One reason why most transactions have been executed through cash payments is that many Indian companies are owned directly by promoter shareholders, who also comprise the management. Overseas sellers of companies are often hesitant to invest through stock swaps in firms they perceive may not always be run “professionally,” according to some private fund insiders. Also, while the Indian capital market is far bigger today with a market capitalization of around $655 billion, it is still small in comparison with markets in other developed economies and not as well tracked or understood.
Moreover, even though several Indian firms have issued stock overseas in the form of American Depository Receipts (ADRs) and listed on overseas stock exchanges, these markets are not liquid enough. “Foreign sellers are not yet confident about accepting payments in the form of equity in Indian companies,” says Ernst & Young’s Desai. “For them it would amount to foreign direct investment, which brings regulatory issues. As for many private equity funds, they don’t yet understand the Indian market well and so are reluctant to accept stock.”
In many cases, the overseas sellers are private equity funds. For instance, Tata Coffee bought Eight O’ Clock Coffee from Gryphon Investors of San Francisco, Calif. The Tata group’s Videsh Sanchar Nigam acquired Teleglobe International Holdings for $239 million in July 2005 from affiliates of the New York-based Cerberus Capital and Tenx Capital Partners. The cash option seems to work well for Indian corporate buyers, too. “Indian promoters are wary of equity swaps because they could dilute their equity base significantly if the acquisition price is high,” says Grant Thornton’s Bhagat. “Moreover, the cost of equity at around 15% is higher than that of debt at around 8%, so paying in cash brings down the cost of the acquisition. Sellers are reluctant to accept stock because they’re not sure about the valuations of the buying firm.” Bhagat, however, believes that some Indian companies with overseas acquisition plans are considering payments in stock.
Deal or No Deal
Indian companies have taken advantage of the huge appetite for Indian paper — both debt and equity — either from banks or from government-designated qualified institutional buyers (QIBs) who are familiar with the Indian market. Many companies have raised large amounts either through loans or “foreign currency convertible bonds” (FCCBs) in the past two years. Borrowings through FCCBs were about $5 billion in 2005 compared with $2.46 billion in 2004, according to government reports. In the April-June quarter of 2006, Indian companies mobilized FCCBs of $2.2 billion, up 273% from the same period in the previous year. Given that India’s equity market has been strong in recent years, companies placing FCCBs have negotiated trigger prices for conversion of the bonds into equity at premiums to the prevailing stock price ranging from 25% to 75%. The conversion at the trigger price is often optional, so the investor is assured of a fixed return and capital protection in the event the stock does not perform. If the share price of the company goes up, the investor benefits from the capital appreciation. For the issuer, this works out as a low cost means of financing, since the FCCB coupon rates are usually 150-200 basis points below the general debt coupon rates.
Two companies that have made good use of FCCBs are Sun Pharma and Wockhardt. They raised $350 million and $100 million, respectively, in 2004-05 through FCCBs at attractive premiums. In Sun Pharma’s case, bondholders could, if they wished, convert the bonds into shares at the trigger price of Rs. 750 a share ($17), which was a 150% premium to the then prevailing market price. The bond was issued at zero coupon and at a 4.6% yield to maturity. Wockhardt raised the money at Rs. 486 a share ($11), which was a 50% premium to the then prevailing market price of Rs. 324 ($7.30) a share. Syndicated loans are generally priced at LIBOR (London Inter-Bank Offer Rate) plus 100-300 basis points and the tenure can vary between one and seven years. For banks, says Rabo Bank’s Bhasin, such loans make lucrative business with handsome spreads.
The odd deal has been funded through leveraged buy-outs — Tata Tea’s acquisition of the British packaged tea brand Tetley in 2000 for $431.2 million and Tata Coffee’s purchase of Eight O’ Clock Coffee. But LBOs as a means of funding deals are yet to catch on among Indian acquirers.
Private equity funds are emerging as a major source of money for Indian acquirers of overseas companies; typically, they are willing to continue to support the companies in which they have already invested. “We are open to follow-on investments to help firms with sound acquisitions plans since we are encouraging them to go global,” says Shankar Narayanan, managing director of the Indian operations of the Carlyle Group, a Washington, D.C.-based private equity fund which globally manages assets worth $35 billion.
Indian companies are also creating new international financial vehicles to route payments and take advantage of favorable tax regimes. The December 2005 acquisition of U.K.-based Keyline by the Mumbai-based Godrej Consumer Products was routed through an SPV (special purpose vehicle) in The Netherlands. Some acquirers have found innovative ways to route payments in a fashion where they can take advantage of tax treaties. One is towel maker Welspun India, which in June 2006 bought British towel brand Christy for £15.6 million ($30 million). Welspun India created a 100% subsidiary in Cyprus (a tax haven) which in turn has a 100% subsidiary in the U.K. called Welspun Home Textiles U.K. The British subsidiary borrowed £10 million from Bank of India. Welspun India paid £5 million to the Cyprus entity, which passed that on to its Welspun U.K. for payment to CHT Holdings, which was Christy’s seller. The loans will be repaid by the dividends from Christy paid to Welspun U.K.
“Tax rules allow the consolidation of accounts of Welspun U.K. and Christy,” explains Akhil Jindal, president, corporate affairs, at Welspun India. “Accordingly, the interest is expensed against the earnings in Christy, reducing the overall tax liability of Welspun U.K. and Christy.” Moreover, if Welspun Home declares a dividend and remits it to the Cyprus entity, there would be no withholding tax, he explains. However, if the dividend had been remitted to India directly, a withholding tax of 15% would have been applicable. Also, had the U.K. entity remitted the dividend directly to India, Welspun India would have been liable to pay taxes at the rate of 33%. Since it is being routed through the Cyprus outfit, the rate of taxation drops to 22%.
In a move that has catalyzed the growth of foreign investment from India, the Indian government in January 2005 removed the cap of $100 million on foreign investments by Indian companies and raised it to the level of net worth of the acquiring Indian firms. In March 2006, India’s central bank — the Reserve Bank of India — eased many of the regulations relating to overseas investment by Indian companies. It cleared the road for proprietary or unregistered partnership firms to set up joint ventures or wholly owned subsidiaries abroad.
With simpler rules and easier access to money, the environment in India for shopping overseas has never been more conducive. What’s more, the experience of the first lot of buyers has been encouraging, and most of them claim to be achieving what they set out to do. “So far, the experience has been good, and since the trend is new we need to give it time,” says Grant Thornton’s Bhagat. “While there will be problems — whether of culture or language — Indian managements should be able to handle them.”